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Tuesday, August 16, 2011

Getting Serious About the Tight Money Problem

The Federal Reserve is now the subject of more political controversy than at any point since the beginning of the 1980s. The debate centers on what the Washington Post calls its “ultra-easy” monetary policy: Is it hurting or helping the economy? Has the Fed already loosened so much that it has used up its ability to stimulate the economy?

It’s a heated debate, but its premise happens to be wrong. We don’t have loose money, and we haven’t during our entire economic slump. A big reason that slump has been so deep and long is that the Fed is keeping money tight: It’s not letting the money supply increase enough to keep current-dollar spending growing at its historical rate.

In other words, by not responding to changes in money demand since the crisis started, the Fed is effectively tightening monetary policy. This passive tightening of monetary policy is just as damaging as an active tightening of monetary policy. The result is that current dollar spending--the product of the money supply and money demand--is not where it should be, as seen in the figure below:

Bruce Bartlett makes a similar point. He says that though the Fed has made some effort, it has not gone nearly far enough to offset the sustained decline in velocity:

[T]he Federal Reserve could have offset the decline in spending and velocity resulting from the fall in home prices with a sufficient increase in the money supply. And it tried. Since 2006, money supply has increased by about $2 trillion. But velocity fell faster than the money supply increased as households reduced spending and increased saving — the saving rate is now over 5 percent — and banks and businesses hoarded cash.

The key, then, is to undo this largely passive tightening of monetary policy. Here is how I would doit.

5 comments:

Excellent blogging. We are running tight money the same way Japan is running tight money.

The markets seem to be saying inflation is dead. Real estate is sinking. CMBS bond values have fallen this year.

The CPI for June 2010 is up 2.6 percent from July 2008. No one believes this, but check it out. That is less than 1 percent annually, and many economists have concluded that the CPI overstates inflation by about 1 percent.

In short, we are dead in the water.

I say it out loud: Print more money and lots of it. I would rather live through an inflationary boom than a prolonged deflationary recession.

But then, I don;t believe the value of a Ben Franklin should be preserved in monetary formaldehyde.